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9/11 and the Impact on Insurance

By Darin Feldman

The incomprehensible tragedy of September 11, 2001 has already been marked as the worst catastrophic event in the history of the insurance industry. The final tally of insurable financial damages is still unknown and will be so for a long time. This uncertainty has unnerved many investors, both equity and fixed income. Consequently, the pricing volatility among insurance company securities has been significant. Some investors have aggressively purchased insurance securities with the expectation that premium rates will surge in response to the losses. Others have shied away from the sector in fear of the financial harm that the industry may be facing. Unfortunately, media headlines are driving many of the investment decisions and not fundamental analysis.

Advocating an investment position in the insurance sector, either to buy or to sell is certainly difficult given the magnitude of the event and unique circumstances that each company faces. But a key factor to consider is that each company in the industry should be treated individually and not lumped together as a whole. Following the attack on September 11, airlines and insurance companies collectively became synonymous with financial distress. In the October 5, 2001 "Heard on the Street" column of The Wall Street Journal, the subtext of the headline reads "The recent attacks directly damaged the aviation, insurance and tourism businesses, but how deeply could other industries have been hurt in the last three weeks of the quarter?" This statement seems fairly innocuous, but is extremely misleading.

While the events certainly impacted airlines and insurance companies to a greater extent than any other sectors, the consequences are dramatically different for the two industries. The primary difference is that September 11 represents for the airline industry as a whole. For insurance companies, the problems will really be limited to individual companies. In fact, many insurance companies stand to significantly benefit from the September 11 events. The key distinction to consider in treating the airlines as an industry problem and insurance companies on a case by case basis is as follows. The terrorist attacks are a major business problem for airlines, but for insurance companies, only the balance sheet has been impaired. The implications of this are that it is a lot easier to fix a balance sheet than it is to fix a business.

An insurance company that has taken a hit to its balance sheet can easily raise more capital if investors are convinced that the pricing environment will yield generous returns. Once this happens, the insurance company has restored its balance sheet strength and now actually has better growth prospects. Obviously, this comes at a cost to the company. However, unlike within the airline industry, the financial losses from this catastrophic event are truly costs of doing business for insurance companies. For the airlines, the event is not a cost of business, it results in the loss of business. The simplest way to see this will be to look at the respective income statements of the two industries in the 3rd quarter. For the airlines, the catastrophe results in a loss of revenue. For insurance companies, the catastrophe is an expense item. Even more telling will be a comparison of the revenue lines for airlines and insurance companies in the fourth quarter. Airlines are likely to see a precipitous decline in revenue. For insurance companies, premium rate increases and higher demand for insurance following the catastrophe should result in visible top line growth for many carriers.

In a somewhat twisted, but interesting way, many insurers view the payment of catastrophe claims as a form of advertising that over the long term, increases the value of the organization via goodwill. On a day-to-day basis, insurers face difficult challenges in promoting the value of its product and differentiating itself from the competition. The product of an insurance company is a promise. This is a promise that in return for a fixed premium, the insurance company will indemnify a policyholder for an insurable and covered loss. Fortunately for most policyholders, the opportunity to collect on that promise does not frequently present itself. However, when a policyholder files a claim with an insurance company, the individual or business has the chance to see what they purchased. A company that effectively handles the claim can have a policyholder for life as well as the benefit of word of mouth advertising. If handled poorly, it will be an insurer’s worst advertising campaign. The bottom line is that insurance is a product that no one likes, but everyone needs. Unfortunately, the best proof of that comes during times of loss.

So does all of this suggest that September 11 automatically created a buying opportunity for insurance securities? Absolutely not. What it does suggest is that well capitalized companies that can withstand the hit to capital from the devastation and be around to reap the benefits of a firmer pricing environment are worth investor consideration. Although the insurance industry as a whole has a significant amount of capital, there are many companies in the sector that are thinly capitalized. Those are the companies that investors should fear. It is this point, which makes it extremely important for investors to pay as much attention to the balance sheet strength of an insurance company as it to look at its earnings. Unfortunately, many investors only appreciate the value of a strong balance sheet after the catastrophe took place. Those companies that have solid balance sheets will reap the benefits of greater product demand. This is not to say that a high frequency of catastrophes is good for insurance investors, because insurance companies are not adequately compensated to pay catastrophic losses on a frequent basis. They are however, most of the time, compensated to cover the large, yet hopefully infrequent losses.

Once again, this article should not be construed as a blanket investment advocacy position for insurance stocks and bonds. Unfortunately, some companies will deeply suffer financially and operationally from the events of September 11. The purpose of this commentary is twofold: First, investors need to understand that the airline and insurance industries were financially impacted by the tragic events of September 11, but in very different and material ways. Second, when a catastrophe does occur, insurance investors should not be concerned with near term earnings implications. The only matter of consequence is balance sheet strength. Ultimately it is a strong balance sheet that enables an insurance company to deliver on its promise, which in turn, increases the value of the franchise. Investors must get past the headlines and look at the fundamentals that drive a business. The events of September 11 are tragic beyond words. But it is important to remember that the main purpose of insurance is to cover unexpected, and sometimes devastating losses. Insurance companies sell protection. For well-capitalized companies that are able to get through the events of September 11, the opportunity to sell more protection should be enormous.